ELS product innovation needed

Kim Hyung-tae
The author, a former president of the Korea Capital Market Institute, is a guest professor to Seoul University.

“Magic is all about turning assumptions and expectations against you,” said Alex Stone, professional writer and practicing magician. The performer, who studied physics at both Harvard and Columbia, claims so-called professionals in certain fields are most easy to fool.

Children are actually the toughest audience for magic. They operate without a lifetime’s understanding of how the world works and have the benefit of figuring out how things actually work because they don’t come with assumptions and expectations.

The so-called experts are confined by the walls of bias. They consider themselves knowers rather than learners and suffer the paradox of expertise. Once a person stops growing, they can be fooled more easily.

Until the exotic concept of equity-linked securities (ELS) first arrived in Korea in 2003, investors thought only of stocks and bonds in the capital markets. The novel hybrid investment instrument created a sensation. Due to high demand, the product has evolved. The most popular type these days are notes linked to the Kospi index or the Hang Seng China Enterprise Index where a knock-out trigger starts at 90 percent of the benchmark value at issuance and steps down to 80 percent, increasing the likelihood of the call kicking in before the note matures. The product born outside the box, however, may be slipping into a new paradox of expertise.

Why are ELS products in Korea so connected to the Hong Kong-listed H index? Experts will say that the complex instrument embedded with a variety of options hinges on the volatility of the underlying reference index. That should be accompanied with the futures and options market that enable hedging against volatility risks. Few reference indices provide both volatility and hedging backups. The list includes the Kospi, Hong Kong H index, S&P 500, Nikkei 225, and the Euro Stoxx 50. The Nasdaq does not offer ELS because it does not have derivatives market. There are no ELS products backed by underlying assets of Nasdaq members like Amazon, Google, Facebook, and NetFlix. Nor are there ELS tracing stocks listed in Spain, Italy, and Russia. ELS products therefore inevitably evolve around selective markets. Brokers prefer the volatile H shares, or ordinary shares of mainland China incorporated companies.

Investors only receive par if the reference price remains above the trigger (55 percent) and lose money when the reference markets shake.

Experts will tell you that over-the-counter (OTC) derivatives are hard to trace and are expensive. But that’s stereotypical and a safe answer from experts who stick to hedging in exchanged derivatives.

ELS products can be structured to link securities in Vietnam and Indonesia if derivatives from the OTC realm are included. It should be within the capacity of a broker to employ OTC derivatives at a lower cost. If a brokerage company can broaden the hedging spectrum to OTC derivatives, it would also dramatically widen the choices in underlying assets.

E-commerce giant Amazon focuses on R&D to develop innovative ways to save time. Sales of fresh foods, like vegetables, fruits, and fish, depend on the delivery time. That’s why the company is so keen on developing self-piloting drones and widening its logistics network.

Just as time is important to e-commerce providers like Amazon, hedging is essential to securities companies designing and selling ELS products. The more hedging instruments made available, the greater the underlying assets it can invest in become. The capacity to make use of OTC derivatives, develop hybrids, or discover assets that correlate well with the stock index would make the brokerage house a global player like Amazon. Local players must look beyond the red ocean of H shares.

Why is it that ELS products are structured to pay a fixed return unless the stock price hits a certain level? Experts would say that’s the appeal of ELS: it pays a relatively higher yield during the low-interest environment. It’s why the product is popular with seniors and retirees. The government offers long-term safe debt securities in the form of treasury bonds.

The financial markets should provide financial instruments that offer security and bigger profits. The capacity becomes strategically important in an economy where low growth and low rates are becoming fixtures.

The ELS market has once again been rocked because of the deterioration in the Hong Kong economy and its stock prices. Domestic brokerage houses have become expert in ELS products due to high demand.

The ELS market is one of the largest in the world. It has matured and requires a new breakthrough for further growth. The ELS market should look beyond H shares and derivatives trading on the exchange. A player who can capitalize on volatility through innovation and insight will be the victor.

Translation by the Korea JoongAng Daily staff

JoongAng Sunday, Nov. 10, Page 35